Oil Production and OPEC's oil Shock

OPEC has surprised the markets with an output cut of 900,000 barrels per day, to take effect at the

beginning of November. Observers had expected the oil producers' cartel to hold its quotas steady because

production in Iraq has been hit by sabotage. Before the regular meeting of the Organization of Petroleum

Exporting Countries (OPEC) in Vienna on Wednesday September 24th, most of the drama was provided by

Hugo Chavez, the Venezuelan president, who opined that the Iraq representative should not have been at

the get-together because he was an illegitimate stooge of American occupiers. If that is so, Ibrahim Bahr al-

Uloum behaved very oddly. His bullish predictions that Iraq could produce at least 3.5m barrels per day

(bpd) by 2005 seem to have been among the factors that persuaded the ten members of OPEC's quota

system to approve a surprise production cut of 900,000 bpd, to 24.5m bpd.

The effect of the cut was to send oil prices sharply higher. Equities in America retreated on fears that a

higher oil price could stymie the incipient economic recovery: the Dow Jones Industrial Average of 30

leading shares fell by 1.57% that day. In their official communique, OPEC's oil ministers pointed to their

expectation of a 'contra-seasonal stock build-up' at the end of this year and the beginning of next year.

Normally, oil stocks decline over the winter in the northern hemisphere, thanks to heavy use of heating oil.

But this year, demand for oil, according to OPEC, will grow merely at its 'normal, seasonal' level, despite

an improving world economy. OPEC expects supply to grow faster than demand, thanks to continued

increases in production from Iraq and non-OPEC countries (of which Russia, the world's second-biggest oil

exporter, is the most important). OPEC expects this supply-demand mismatch to translate into a stock

increase of 600,000 bpd in the final quarter of this year. This contrasts with an estimated stock reduction of

500,000 bpd in the final quarter of 2001, and 1m bpd in the last quarter of 2002. Larry Goldstein, president

of the Petroleum Industry Research Foundation, believes OPEC has got its sums wrong. In remarks to the

Wall Street Journal, he said he thought stocks would be flat over the coming three months. Although the

communique did not explicitly say so, OPEC members are keen to keep worldwide oil stocks below their

ten-year average. That would give the cartel more power to determine the price. American oil stocks have

been creeping up again after hitting 26-year lows earlier this year. America's energy secretary, Spencer

Abraham, was clearly disappointed by OPEC's move, saying: 'Sustained global economic growth requires

abundant supplies of energy. The US believes oil prices should be set by market forces in order to ensure

adequate supplies.' America's opposition Democrats have been even more outspoken. Last month, they

publicly rebuked Saudi Arabia, OPEC's (and the world's) leading producer, for reducing exports in August,

thus causing an unpopular rise in American petrol prices. Some observers are also speculating that OPEC

may be sneakily trying to shift its price target above the current $22-28 range (per barrel, for a basket of

Middle Eastern crudes, which tend to trade a couple of dollars below West Texas crude). After all, the oil

price has been well within that range for the past few months. Why cut production when current supply

levels are achieving their aim? In fact, the oil price has stayed higher than many expected: it was widely

expected to fall well below $20 per barrel after the end of the Iraq war. However, unrest in Nigeria, a big

producer, and the continuing attacks on Iraq's oil facilities put paid to that. OPEC's fears about non-OPEC

production may be well-founded. After decades of communism, the industry in Russia is ramping up output:

so far this year, it has been pumping an average of 800,000 bpd more than last year. Oil and gas are the

country's biggest exports, earning hard currency that is seen as a key ingredient of economic revival.

Moreover, the oil industry is in private hands, so even if the government in Moscow wanted to put a lid on

production, it has less influence over its oil companies than OPEC governments have over theirs. The

president of OPEC, Abdullah bin Hamad al-Attiyah, told the Wall Street Journal that the cartel would not

cut production below 24m bpd unless big oil exporters outside OPEC, including Mexico and Norway as

well as Russia, were prepared to cut production too. OPEC's stance on Iraq is very different. Here, the cartel

seems to be taking an overly rosy view. Iraq says it is currently producing around 1.8m bpd, well below the

2.5m bpd that it was pumping before the country was invaded in the spring (and even that was well below

its potential, owing to years of sanctions). Moreover, exports, which are a crucial source of revenue for

reconstruction, are still running at only about 500,000 bpd, compared with 2m bpd before the war. These

have been seriously disrupted, and continue to be threatened by sabotage. Currently, oil is being exported

mainly through the north: the southern ports on the Gulf coast are operating far below capacity. For those

who take OPEC's optimistic view of Iraqi production at face value, the cartel's move should not have come

as a surprise. But the sharp reaction from oil markets and stock markets suggests it did. Many speculators

had sold oil in the futures market, or 'shorted' it, expecting the price to fall in the short term - they clearly

weren't expecting a big cut in output quotas any time soon. According to the Commodity Futures Trading

Commission, the American regulator for commodity futures markets, the increase in short positions over

September was equivalent to 470,000 barrels of oil. OPEC's decision led to a scramble to 'cover' such

positions by buying oil. Whether prices. Stay higher will depend on two key factors. Will OPEC members

stick to their new quotas? (They have a history of cheating.) And will Iraqi militants continue to destroy

their own country's wells and pipelines?

Questions:

a). OPEC currently produces about 38 per cent of the world output of oil. Assuming the short-term price

elasticity of demand is -0:28 estimate the effect of the output cut on the current price, stating any assumptions

in your calculations.

b). Describe the factors currently driving the world demand for oil; why has the price not fallen below the $20

level as many expected?

c) . Explain the effect of other non-OPEC producers on the cartel's output decisions.